Boxed sets of series one to three of Channel 4's teen drama Skins can be bought online for £17.99, just under the threshold of £18 at which VAT applies Photograph: Channel 4

The controversial online sale of VAT-free CDs exploded at the end of last year, driving one in three purchases by British music-lovers on to the web. The surge in sales casts doubt over Treasury claims to be tackling the tax dodge, already thought to be costing the exchequer £110m a year and rising.

Websites operated by HMV, Tesco, Amazon, Play.com, Asda, WH Smith and Woolworths structure almost all their online CD and DVD transactions as personal imports from the Channel Islands. As a result they are able to offer unbeatable VAT-free prices, threatening the futures of music stores and sapping tax revenues.

Data from market research firm Kantar shows that 16.5m CDs were bought by British customers over the internet in the last three months of 2009 at an average price of £7.80. Over the same busy pre-Christmas period, 26.6m DVDs were bought online at an average price of £9.36.

In most cases, customers remain unaware of the extraordinary lengths online firms are going to to ensure the buyer avoids the 17.5% VAT charge they would pay on the same product bought from their local store. What appears a simple online purchase exploits a 27-year-old European tax directive that waives VAT charges on low-value personal imports from outside the EU. In the UK, the VAT relief applies to goods bought for £18 or less.

Tax-free internet sales from the Channel Islands have been steadily ballooning over the past 10 years while the Entertainment Retailers Association claims 1,600 shops selling music have closed in the last five years. Among the high street names to have failed, or to have disappeared altogether, are Fopp, Our Price, MVC, Music Zone, Virgin Megastores, Tower Records, Zavvi and Woolworths.

While the number of CDs bought online soared by 18% last year, – including a 37% rise over the busy final three months – Kantar's figures show that music sales volumes at traditional music stores and retailers on the high street declined by 33%. And as stores such as Zavvi and Woolworths have slipped into administration, Channel Islands operators have stepped in to resurrect the brands online – again offering VAT-free prices.

Kantar data shows 5% of online DVD transactions are above £18, the threshold at which the VAT exemption no longer applies. The proportion of CDs bought on the web for more than £18 is so tiny as to be "statistically insignificant", Kantar said.

Mike Dillon, who has run independent store Apollo Music in Paisley since the 1970s, said last Christmas was his worst, blaming unfair competition from VAT-avoiding online operators. "We are very competitive on price. We try to sell chart CDs for a tenner but it's not always possible. I doubt if we have any customers who don't already buy CDs online. The government has a duty to collect all the taxes that are applicable. Shops are shutting, people are losing their livelihoods, jobs they have had for years. It's absolute negligence."

Alison Wenham, chief executive of the Association of Independent Music, representing small record labels and distributors, said: "This is a hidden disease within the music business. It is very simple to resolve, but what we are getting from government is a denial of reality."

When the Guardian reported last summer that the Treasury was understating the extent of the ballooning online retailing tax dodge, Treasury minister Stephen Timms ordered an internal review be carried out by department officials and HM Revenue and Customs. In a leaked letter written after the review, Timms privately attacked the Guardian claims. "The article ... has exaggerated the level of exports made by some of the businesses it mentions ... [It] also fails to explain that most of the businesses it mentions, including the proposed launch of a Woolworth retail site, are not actually new businesses based in the islands ... the [CDs and DVDs] are owned and despatched by a fully licensed and established Jersey company, under contract to the major retailers," he told Tory MP Sir Peter Tapsell, who had aired a constituent's grievance on the matter.

In fact, the Guardian investigation had found that all but one of the companies involved in the VAT dodge were controlled by UK-registered parent businesses. Maidenhead-based HMV Group and Swindon-based WH Smith – both stock exchange-listed – push much of their online sales through subsidiaries HMV Guernsey and WH Smith Jersey.

Amazon has an arrangement with Indigo Starfish, a Jersey company owned by Glasgow-registered parent Indigo Lighthouse, while Tesco, Asda, Argos and WH Smith have struck outsourcing deals with ­Cheshire-based The Hut, which operates through Jersey and Guernsey subsidiaries. The only genuinely Channel Islands-owned company using the VAT loophole is Play.com, founded by islanders Richard Goulding and Simon Perree. The Guardian has been unable to find any mainstream website that does not offer CD or DVD sales via the Channel Islands VAT loophole.

Timms was not available to comment this week and has repeatedly turned down requests to talk to the Guardian about online VAT-free sales. the Treasury said: "The implication that businesses are simply setting up on the Channel Islands to take advantage of this relief is not true. In fact exports from the Channel Islands account for a very small percentage of the CD/DVD market".

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